Dependencies and business interruption

Generally speaking Business Interruption Insurance is always triggered by indemnifiable property damage, though there are some exceptions when certain extensions are incorporated into the insurance policy wording (e.g. the business is affected by a damage that occurs outside of the premises of the Insured). Therefore you have to take a wider perspective when you look at your Business Interruption cover and take into consideration the dependencies of your own business.

It is not an easy task but nevertheless a very important one. In addition, dependencies also have a tendency to cause accumulation problems, which is why mapping the risks is very important, not only for the Insured but also for the Insurer. Dependencies can be both internal and external.

This article focuses on the following types of dependencies:

• Interdependencies
• Suppliers and Customers
• Public Utilities
• Denial of Access 

Interdependencies

If a company within a group is dependent upon other companies within the same group this causes interdependencies. If each company is insured separately to cover the business interruption risk then each company has to have a Suppliers and Customers extension.

These extensions often have a stipulated limit, which is why there is a risk that the limit may not be enough. Another way to insure the interdependency risks is to have a group solution, which covers the business interruption loss of the group, and not have a solution based solely on the individual subsidiary company level.

This method of insuring is a better way of protecting the financial risk of the group, which in most cases should be the Insured’s main aim at group level.  On the other hand the Insurer is reluctant to insure any unknown risks why they need to include a limit for interdependencies if such are unknown.

Suppliers and Customers

A company is nearly always dependent on services from suppliers. However, a company can also be dependent upon suppliers’ suppliers, to ensure that services/products are delivered to the customers. If the company does not get the required services/products from the suppliers it will have a financial impact on the business. This could result in higher costs, having to choose another more expensive supplier, or even in lost business.

There is insurance available that can offer protection to the Insured for the financial effects of damage occurring at the supplier/customer. However, this cover is subject to the proviso that the damage is indemnifiable (normally with a FLEXA cover).

If the damage is not indemnifiable it is considered a business risk and not an insurable risk. What happens if the problems start at a suppliers´supplier? The normal extension does not cover this type of risk. However, subject to a special agreement with an insurance company such risks can might be covered.

Claims due to damage that occur at a supplier are more and more common. At If P&C these types of claims have increased during the last couple of years. One reason could be that more complex products involve more sub-suppliers. Another aspect affecting the risk is the level of the stock. If you have a lean production system using the just-in-time principle then there is no space for problems in the supply chain.

Insurance claims due to damage occurring at customers are much less common than claims due to damage occurring at suppliers. One can ask why? Has the insured simply forgotten to notify the insurance company about a potential claim or is it easier to find a new customer than a new supplier?

The significance of companies' dependency on suppliers and customers

The catastrophe in Japan has highlighted the significance of companies’ dependency on suppliers and customers. The car industry is a good example. The lack of a small component can make it impossible to deliver the end product, the car. If a supplier/sub-supplier has a very strong position in the market then the risk of a huge impact is even greater. These NatCat risks are very hard to estimate and the consequences can be devastating.

When considering the sums insured for the Suppliers and Customers extension one often talks about named and unnamed parties where the limit is often higher for named parties. It is easier both for the Insured and the Insurer to pinpoint a risk and calculate the risk if the supplier/customer is identified.

One problem both the Insurer and the Insured have in common regarding this risk is that it is very hard to control and affect the physical risk at a named or unnamed supplier/customer. This makes it hard to calculate the real risk. Limits are a way for the insurer to minimize the effects of risk miscalculations.

When it comes to an unnamed supplier/customer the control is even weaker and therefore the limits for the sum insured are even lower. How do you minimize the risk and consequences when trouble arises at the premises of suppliers and/or customers?

Deal with it or be proactive

One way is to try and deal with it after the problems have started. Another method is to try to be proactive and minimize the risks before they have created a problem. One way to be proactive is to have a purchasing/customer policy stating that the company shall have at least some alternative suppliers and not be too dependent upon too few clients. Do not put too many eggs in the same basket!

The contracts can also be written in a way that the risk is minimized by using penalties or clauses that stipulate that the suppliers have to cooperate if something happens, etc. One can also demand that the supplier has an all-risk insurance to improve the possibility that the supplier has the means, for example, to rebuild after a fire.

One way of knowing your risk is to map it using a business continuity plan, which includes the dependency risks. It is a bit like the elite athletes and their preparation before competitions, which includes both physical and mental training. A problem that can arise if there is a loss at a supplier or a customer is in regards to claims handling.

It is much harder to discover the root cause of the claim, which is very important in Machinery Breakdown claims, i.e. to determine whether the loss is indemnifiable or not. Neither the Insured nor the Insurer has direct access to the place where the breakdown happened. It is also much harder to mitigate the loss since the decisions for expediting operations etc. are not decided directly by the Insured. It is even harder if the damage happens at a suppliers' supplier.  

Public Utilities

To be able to manufacture products/deliver services the business is almost always dependent upon public utilities such as electricity, gas, water, etc. If there is an unforeseen interruption in a delivery there is an extension that can cover the effects of such an interruption.

If it is a planned stoppage it is not covered under the extension. There is an argument for stating that such an unforeseen interruption could also be indemnified under the extension for named/unnamed suppliers. 

Denial of Access

There are different types of extensions for Denial of Access. One type is coverage for Denial of Access due to an indemnifiable loss occurring in the vicinity of the insured’s premises.

Another type is cover for an unforeseen shut down decided upon by a public authority. For example in a bomb threat physical damage has not actually taken place and the business interruption loss is not covered if you do not have the relevant extension for Denial of Access.  

Waiting period and dependencies

The normal way of insuring Business Interruption is to have a specific indemnity period, a sum insured, which is normally the annual gross profit and a certain waiting period, which is a kind of deductible based on a time element. The most common way is to have the same waiting period for both the normal Business Interruption coverage and for the dependencies.

The waiting period works as intended if there is a property claim at the Insured’s production site. The principle is that the indemnity period starts from the occurrence of the indemnifiable property damage. When the insurer indemnifies the loss the economic consequences due to problems in the production process during the waiting period are deducted from the overall loss.

If you apply the same principles to a damage occurring at say a supplier there might not be any effect on the Insured’s production process for a long period due to, for example safety stock/delivery times etc. The waiting period in such claims will be consumed as the principle of occurrence will tick and take away the share of the loss meant to be retained by the Insured.

A way of avoiding this is to have a monetary deductible regarding dependencies, which could correspond to the waiting period on normal Business Interruption claims. Another way is to have a combination of a minimum deductible in monetary terms and a waiting period. The wording could also be rewritten to clarify how to apply the waiting period and how to calculate the indemnifiable loss. 

Summary

To be able to minimize the risks for your business it is very important to map not only the risks within your company but to have a wider perspective. The Business Continuity Plan must include the dependency risks. When the risks are known it is very prudent to minimize those risks by working proactively.

When that is done the appropriate insurance cover will have to be created to cover the risks still remaining. Through this working method you will minimize the actual risks, sleep better and hopefully also have a more accurate sum insured which could save you a lot in premiums!

Text revisited in October 2021. Original article published in If News,  Lessons from Losses 6/2011.